Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Short-term gains, long-term problems in the US
Christopher Dembik
Head of Macroeconomic Research
Summary: In a short-term, pre-midterms sense, the US economy is pretty much as robust President Trump claims it is. Once you dig into the details on the real estate and deficit fronts, however, the picture grows decidedly cloudier.
• The Republicans could win the midterm elections.
• The US economy is not as great as it seems; housing and autos are experiencing a significant downturn.
• The rising deficit is the US' main long-term issue.
A big win for Trump?
Anyone who has ever participated in an election campaign knows perfectly well that the last weeks of the campaign are decisive. This proves to be the case once again in the US midterms. If I had written this analysis three weeks ago, I would have certainly asserted that Democrats are likely to win a majority of seats in the House of Representatives and that the Senate should remain controlled by the Republicans.
Over the past few weeks, the situation in the Senate has not changed. But, to everyone’s surprise, the latest polls indicate that Republicans may be able to fend off Democrat efforts to take back control of the House. Democrats are not certain to win a majority anymore. Of the 69 seats still undecided, Republicans have reduced the voting gap to a small margin in almost all of them. Victory will depend on the outcome of the election in less than four to eight districts.
The Democrats made a big mistake betting that the midterms would end up as a referendum on Trump. The President has done surprisingly well with a job approval close to its highest level, around 44%, while Democrats lost ground because they were unable to address local issues.
• The US economy is not as great as it seems; housing and autos are experiencing a significant downturn.
• The rising deficit is the US' main long-term issue.
A big win for Trump?
Anyone who has ever participated in an election campaign knows perfectly well that the last weeks of the campaign are decisive. This proves to be the case once again in the US midterms. If I had written this analysis three weeks ago, I would have certainly asserted that Democrats are likely to win a majority of seats in the House of Representatives and that the Senate should remain controlled by the Republicans.
Over the past few weeks, the situation in the Senate has not changed. But, to everyone’s surprise, the latest polls indicate that Republicans may be able to fend off Democrat efforts to take back control of the House. Democrats are not certain to win a majority anymore. Of the 69 seats still undecided, Republicans have reduced the voting gap to a small margin in almost all of them. Victory will depend on the outcome of the election in less than four to eight districts.
The Democrats made a big mistake betting that the midterms would end up as a referendum on Trump. The President has done surprisingly well with a job approval close to its highest level, around 44%, while Democrats lost ground because they were unable to address local issues.
How strong is the US economy?
Strong GOP support is mainly explained by voters feeling robust about the economy, and giving President Trump credit for it. The consumer confidence rate is close to its record high, wage increases are back to pre-crisis levels and the unemployment rate is below its 2007 level. Even the traditional U6 rate of unemployment – a broad measure that covers the percentage of the labour force that is unemployed, underemployed and discouraged – is slightly below its pre-crisis level, at 7.5% in September 2018 versus 8% before the outbreak of the financial crisis.
However, this rather positive picture does not mean that the risk of a recession is not high in the next two years. Since the early 1950s, seven of the last 10 US business cycles have ended with an abrupt slowdown in just a few quarters. It is very rare for the US economy to experience a soft landing, which would make it easier to forecast the risk of recession. We all know that a recession is coming, but we don’t know when.
When we see it, it will be too late.
So far, the strong performance of the US economy has been mainly driven by the massive effect of the Trump administration's tax reform, which continues to have positive impact on SMEs, and by rising imports ahead of the upcoming tariffs implemented from next January.
Excluding housing and autos, I suppose President Trump is completely right: the US economy is in perfect shape. The problem is that these two key economic sectors for growth show serious signs of weakness. Auto sales are now in contraction, compared to the same period last year, which will seriously affect outlook for clearing 2018 models and bringing 2019 models on stream.
Strong GOP support is mainly explained by voters feeling robust about the economy, and giving President Trump credit for it. The consumer confidence rate is close to its record high, wage increases are back to pre-crisis levels and the unemployment rate is below its 2007 level. Even the traditional U6 rate of unemployment – a broad measure that covers the percentage of the labour force that is unemployed, underemployed and discouraged – is slightly below its pre-crisis level, at 7.5% in September 2018 versus 8% before the outbreak of the financial crisis.
However, this rather positive picture does not mean that the risk of a recession is not high in the next two years. Since the early 1950s, seven of the last 10 US business cycles have ended with an abrupt slowdown in just a few quarters. It is very rare for the US economy to experience a soft landing, which would make it easier to forecast the risk of recession. We all know that a recession is coming, but we don’t know when.
When we see it, it will be too late.
So far, the strong performance of the US economy has been mainly driven by the massive effect of the Trump administration's tax reform, which continues to have positive impact on SMEs, and by rising imports ahead of the upcoming tariffs implemented from next January.
Excluding housing and autos, I suppose President Trump is completely right: the US economy is in perfect shape. The problem is that these two key economic sectors for growth show serious signs of weakness. Auto sales are now in contraction, compared to the same period last year, which will seriously affect outlook for clearing 2018 models and bringing 2019 models on stream.
The most disturbing signal is the slowdown in the real estate market. Existing home sales are experiencing their sixth consecutive month of decline. Over the last 20 years, this has occurred just three times: in 1999 (before the bursting of the internet bubble), in 2007 (during the housing crisis), and in 2013. This steady decline is rather surprising considering that it happens while consumer confidence is at its highest point. In addition, residential investment fell 4%, marking the third straight quarterly decline since late 2008/early 2009. This is highly significant as “residential investment consistently and substantially contributes to weakness before the recessions”, according to the Federal Reserve Bank of Kansas City.
So far, the market has paid very little attention to the acceleration of the slowdown in housing and autos since investors have been too busy scrutinising the latest geopolitical developments on both sides of the Atlantic. This is, however, a major evolution which constitutes another signal that the US is at the end of the business cycle and that we should expect lower growth in 2019.
How bad is the deficit situation?
In the short-term, President Trump has still some leverage to extend the cycle by one or two quarters, especially by lowering taxes for the middle class. Such a measure could be announced a few days before the election day. This could support consumption and growth in the same manner as did the tax credits enacted by presidents Bush and Obama (with the difference that they were implemented in a period of sharp slowdown) and mobilise Trump’s supporters to vote.
As a seasoned businessman, President Trump certainly knows that in business strategy, as in politics, short-term gains are often the cause of long-term problems.
Trump’s burgeoning budget deficit in a period of growth is dangerously limiting the government’s ability to step in when the next crisis will occur – which is a matter of a few years at most. The 12-month rolling US deficit is approaching $1 trillion, a level that has never been experienced in a period of strong growth. According to forecasts from the Congressional Budget Office, the US federal deficit could return to the peak of the financial crisis in 10 years, if a recession does not occur before.
How bad is the deficit situation?
In the short-term, President Trump has still some leverage to extend the cycle by one or two quarters, especially by lowering taxes for the middle class. Such a measure could be announced a few days before the election day. This could support consumption and growth in the same manner as did the tax credits enacted by presidents Bush and Obama (with the difference that they were implemented in a period of sharp slowdown) and mobilise Trump’s supporters to vote.
As a seasoned businessman, President Trump certainly knows that in business strategy, as in politics, short-term gains are often the cause of long-term problems.
Trump’s burgeoning budget deficit in a period of growth is dangerously limiting the government’s ability to step in when the next crisis will occur – which is a matter of a few years at most. The 12-month rolling US deficit is approaching $1 trillion, a level that has never been experienced in a period of strong growth. According to forecasts from the Congressional Budget Office, the US federal deficit could return to the peak of the financial crisis in 10 years, if a recession does not occur before.
One key and increasingly apparent risk is that the US will not be able to implement a countercyclical fiscal policy when such a move is most needed. The US' ability to recover fast from a crisis is based on both monetary and fiscal stimulus. The Fed's accommodative monetary policy was decisive for the recovery in 2010 but it is the policy mix that pushed households to be more optimistic and spend again.
Americans are mistaken if they believe that foreigners will perpetually continue to finance their expensive way of life. Although it will take decades and encounter many challenges, the process of dedollarisation is unstoppable. Treasury purchases by foreigners fell by half this year, and the dollar’s share of foreign exchange reserves at the global level dropped to a five-year low of 62.5%. In the long run, the US dollar will retain its status as a reserve currency, but it will have to compete with the Chinese yuan, and foreign investors will certainly be much more vigilant before financing the abysmal US deficit.
Americans are mistaken if they believe that foreigners will perpetually continue to finance their expensive way of life. Although it will take decades and encounter many challenges, the process of dedollarisation is unstoppable. Treasury purchases by foreigners fell by half this year, and the dollar’s share of foreign exchange reserves at the global level dropped to a five-year low of 62.5%. In the long run, the US dollar will retain its status as a reserve currency, but it will have to compete with the Chinese yuan, and foreign investors will certainly be much more vigilant before financing the abysmal US deficit.
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